QUALIPORT
Invest At Point Of Maximum Pessimism

By Bruce Jackson (TMFGoogly)
June 28, 2001

It's easy to let the stock market get you down. Last year was a down year, and if you were invested in telecoms, media and technology (TMT) shares, it was probably a BIG down year. The stock market is down again this year. The Footsie back at 7000 seems light years away.

The rapid slowing of the US economy has taken many companies by surprise. European economies are a little behind the US curve, but there are definitely signs of weakness over this side of the Atlantic. Things are going to get worse before they get better.

Before going on to look at some investing opportunities this downturn may present, let me be clear as to why the economic situation is how it is.

Irrational exuberance. Free money. Unrealistic growth projections. Over-capacity. Herd mentality. Stupidity.

You get the picture?

Something had to give. First it was the unrealistic growth projections. Next to give was the free money. Companies started going bust, or realising they'll struggle ever to make a profit. Jobs were cut. People stopped spending money. Second hand computer kit started flooding the market. Companies stopped spending money. End result? Recession. Easy to see it coming, wasn't it? (In hindsight I mean!)

Recessions

But all is not lost. Recessions come and go. We usually have one about every 5 -7 years. We had a mini recession in about 1994, and before that in about 1989-90. We're not looking at anything drastically different here.

Canny investors can take advantage of recessions. Share prices are usually marked down, some rather savagely, as profit warnings proliferate in the market. This week is no exception -- Michael Page (LSE: MPI) and Trafficmaster (LSE: TFC) being two notable examples. The former has only recently floated, the latter has long been a stock market darling. The market can be very unforgiving.

As an investor, you have to work out whether the economic downturn is temporary or permanent. There will be a few people out there willing to tell you this is another Japan situation, and we can look forward (sic) to 12 years of recession and 12 years of severe stock market pain. History says otherwise. Recessions go, and are replaced by periods of economic growth. There's no reason to think it's going to be different this time.

As an investor, you also have to work out whether an individual company's downturn is temporary or permanent. Take Trafficmaster, mentioned above. In its profit warning it said "Sales volumes have taken longer to start growing than we had expected as we have been building up and training the substantial sales force necessary to target each of these markets." Temporary (sales have just been delayed rather than scrapped) or permanent (customers are just not buying the product, and nor will they in great volumes) problems? Not easy, is it?

Maximum Pessimism

Invest at the time of maximum pessimism. That's when the margin of safety is at its greatest. When is the time of maximum pessimism? That's the great conundrum. I like to look at the price to sales ratio (PSR) as an indicator. Companies with historic operating margins above 12% and trading on a PSR of less than 1 are probably a good place to start your search. Two warnings -- watch out for their debt levels, and cheap crap is still crap. You still need to look for companies with sustainable competitive advantages.

A Rentokil Case Study

Former Qualiport holding Rentokil Initial (LSE: RTO) provides an interesting case study. It was a former stock market darling, consistently trading at a premium rating. In 1998, its average price to earnings ratio (P/E) was 36 -- some premium! But then, relatively suddenly, the growth story stopped. The shares plunged from a peak of 477p in 1999 to a low point of 124p in 2000. Ouch!

At that low point, Rentokil traded on a PSR of about 1, despite its historic operating margins being above 18%. A bargain? In hindsight, obviously yes, as today the shares trade at about 245p -- a 100% gain in a little over a year. Could you have picked the bottom, buying Rentokil at 124p? Almost certainly not. But the shares did trade around the 140p - 150p range for an extended period during 2000. That was the time of maximum pessimism.

Could Hays (LSE: HAS) be the next Rentokil? Also a former stock market darling, it recently warned that profits would be lower than expectations. The shares plunged. At about 170p, they trade on a PSR of about 1.3. Historic operating margins are around the 13% level. The shares would have to fall to about 130p for Hays to trade on a PSR of one. Possible? Anything's possible. Likely? Probably not.

But, for Hays, that point just could be the point of maximum pessimism.